Chapter 10
Accounts Receivable
and Inventory
Management
10-1
© 2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
Accounts Receivable and
Inventory Management
10-2

Credit and Collection
Policies

Analyzing the Credit
Applicant

Inventory Management and
Control
Credit and Collection
Policies of the Firm
Quality of
Trade Account
Length of
Credit Period
(1) Average
Collection Period
(2) Bad-debt
Losses
Possible Cash
Discount
10-3
Firm
Collection
Program
Credit Standards
Credit Standards -- The minimum quality
of credit worthiness of a credit applicant
that is acceptable to the firm.
Why lower the firm’s credit standards?
10-4
The financial manager should continually
lower the firm’s credit standards as long as
profitability from the change exceeds the
extra costs generated by the additional
receivables.
Credit Standards
Costs arising from relaxing
credit standards
10-5

A larger credit department

Additional clerical work

Servicing additional accounts

Bad-debt losses

Opportunity costs
Example of Relaxing
Credit Standards
Basket Wonders is not operating at full capacity
and wants to determine if a relaxation of their
credit standards will enhance profitability.

The firm is currently producing a single
product with variable costs of $20 and selling
price of $25.

Relaxing credit standards is not expected to
affect current customer payment habits.
10-6
Example of Relaxing
Credit Standards

Additional annual credit sales of $120,000 and an
average collection period for new accounts of 3
months is expected.

The before-tax opportunity cost for each dollar of
funds “tied-up” in additional receivables is 20%.
Ignoring any additional bad-debt losses
that may arise, should Basket Wonders
relax their credit standards?
10-7
Example of Relaxing
Credit Standards
Profitability of
additional sales
($5 contribution) x (4,800 units) =
$24,000
Additional
receivables
($120,000 sales) / (4 Turns) =
$30,000
Investment in
add. receivables
($20/$25) x ($30,000) =
$24,000
Req. pre-tax return
on add. investment
(20% opp. cost) x $24,000 =
$4,800
Yes!
10-8
Profits > Required pre-tax return
Credit and Collection
Policies of the Firm
Quality of
Trade Account
Length of
Credit Period
(1) Average
Collection Period
(2) Bad-debt
Losses
Possible Cash
Discount
10-9
Firm
Collection
Program
Credit Terms
Credit Terms -- Specify the length of time
over which credit is extended to a customer
and the discount, if any, given for early
payment. For example, “2/10, net 30.”
Credit Period -- The total length of time over
which credit is extended to a customer to
pay a bill. For example, “net 30” requires
full payment to the firm within 30 days from
the invoice date.
10-10
Example of Relaxing
the Credit Period
Basket Wonders is considering changing its
credit period from “net 30” (which has resulted
in 12 A/R “Turns” per year) to “net 60” (which is
expected to result in 6 A/R “Turns” per year).
 The
firm is currently producing a single product
with variable costs of $20 and a selling price of
$25.
 Additional
annual credit sales of $250,000 from
new customers are forecasted, in addition to the
current $2 million in annual credit sales.
10-11
Example of Relaxing
the Credit Period
 The
before-tax opportunity cost for each dollar
of funds “tied-up” in additional receivables is
20%.
Ignoring any additional bad-debt losses
that may arise, should Basket Wonders
relax their credit period?
10-12
Example of Relaxing
the Credit Period
Profitability of
additional sales
($5 contribution)x(10,000 units) =
$50,000
Additional
receivables
($250,000 sales) / (6 Turns) =
$41,667
Investment in add.
($20/$25) x ($41,667) =
receivables (new sales) $33,334
Previous
receivable level
10-13
($2,000,000 sales) / (12 Turns) =
$166,667
Example of Relaxing
the Credit Period
New
receivable level
($2,000,000 sales) / (6 Turns) =
$333,333
Investment in
add. receivables
(original sales)
$333,333 - $166,667 =
$166,666
Total investment in
add. receivables
$33,334 + $166,666 =
$200,000
Req. pre-tax return
on add. investment
(20% opp. cost) x $200,000 =
$40,000
10-14
Yes!
Profits > Required pre-tax return
Credit and Collection
Policies of the Firm
Quality of
Trade Account
Length of
Credit Period
(1) Average
Collection Period
(2) Bad-debt
Losses
Possible Cash
Discount
10-15
Firm
Collection
Program
Credit Terms
Cash Discount Period -- The period of time
during which a cash discount can be taken for
early payment. For example, “2/10” allows a
cash discount in the first 10 days from the
invoice date.
Cash Discount -- A percent (%) reduction in
sales or purchase price allowed for early
payment of invoices. For example, “2/10”
allows the customer to take a 2% cash discount
during the cash discount period.
10-16
Example of Introducing
a Cash Discount
A competing firm of Basket Wonders is
considering changing the credit period from
“net 60” (which has resulted in 6 A/R “Turns”
per year) to “2/10, net 60.”
 Current
annual credit sales of $5 million are
expected to be maintained.
 The
firm expects 30% of its credit customers (in
dollar volume) to take the cash discount and
thus increase A/R “Turns” to 8.
10-17
Example of Introducing
a Cash Discount
 The
before-tax opportunity cost for each dollar
of funds “tied-up” in additional receivables is
20%.
Ignoring any additional bad-debt losses
that may arise, should the competing firm
introduce a cash discount?
10-18
Example of Using
the Cash Discount
Receivable level
(Original)
($5,000,000 sales) / (6 Turns) =
$833,333
Receivable level
(New)
($5,000,000 sales) / (9 Turns) =
$555,556
Reduction of
investment in A/R
$833,333 - $555,556 =
$277,777
10-19
Example of Using the
Cash Discount
Pre-tax cost of
the cash discount
.02 x .3 x $5,000,000 =
$30,000.
Pre-tax opp. savings
on reduction in A/R
(20% opp. cost) x $277,777 =
$55,555.
Yes!
Savings > Costs
The benefits derived from released accounts
receivable exceed the costs of providing the
discount to the firm’s customers.
10-20
Seasonal Dating
Seasonal Dating -- Credit terms that
encourage the buyer of seasonal products
to take delivery before the peak sales period
and to defer payment until after the peak
sales period.

Avoids carrying excess inventory and the
associated carrying costs.

Accept dating if warehousing costs plus the
required return on investment in inventory exceeds
the required return on additional receivables.
10-21
Credit and Collection
Policies of the Firm
Quality of
Trade Account
Length of
Credit Period
(1) Average
Collection Period
(2) Bad-debt
Losses
Possible Cash
Discount
10-22
Firm
Collection
Program
Default Risk and
Bad-Debt Losses
Present
Policy
Demand
Incremental sales
Default losses
Original sales
Incremental Sales
Avg. Collection Pd.
Original sales
Incremental Sales
10-23
$2,400,000
Policy A
Policy B
$3,000,000 $3,300,000
$ 600,000 $ 300,000
2%
10%
18%
2 months
3 months
1 month
Default Risk and
Bad-Debt Losses
Policy A
Policy B
Additional sales
$600,000
Profitability: (20% contribution) x (1)
120,000
Add. bad-debt losses: (1) x (bad-debt %)
60,000
Add. receivables: (1) / (New Rec. Turns)
100,000
Inv. in add. receivables: (.80) x (4)
80,000
Required before-tax return on
additional investment: (5) x (20%)
16,000
7. Additional bad-debt losses +
additional required return: (3) + (6)
76,000
$300,000
60,000
54,000
75,000
60,000
1.
2.
3.
4.
5.
6.
8. Incremental profitability: (2) - (7)
10-24
44,000
Adopt Policy A but not Policy B.
12,000
66,000
(6,000)
Collection Policy
and Procedures

Letters

Phone calls

Personal visits

Legal action
10-25
Bad-Debt Losses
Collection
Procedures
The firm should increase collection
expenditures until the marginal
reduction in bad-debt losses equals
the marginal outlay to collect.
Saturation
Point
Collection Expenditures
Analyzing the
Credit Applicant

Obtaining information on the
credit applicant

Analyzing this information to
determine the applicant’s
creditworthiness

Making the credit decision
10-26
Sources of Information
The company must weigh the amount
of information needed versus the time
and expense required.
Financial statements
 Credit ratings and reports
 Bank checking
 Trade checking
 Company’s own experience

10-27
Credit Analysis
A credit analyst is likely to utilize
information regarding:





10-28
the financial statements of the firm
(ratio analysis)
the character of the company
the character of management
the financial strength of the firm
other individual issues specific to
the firm
Sequential
Investigation Process
The cost of investigation (determining
the type and amount of information
collected) is balanced against the
expected profit from an order.
An example is provided in the following
three slides 10-30 through 10-32.
10-29
Sample Investigation
Process Flow Chart (Part A)
Pending Order
Stage 1
$5 Cost
No
Bad
past credit
experience
Yes
Reject
No prior experience whatsoever
Stage 2
$5 - $15
Cost
Dun & Bradstreet
report analysis*
* For previous customers only a Dun & Bradstreet reference book check.
10-30
Sample Investigation
Process Flow Chart (Part B)
Credit rating
“limited” and/or other
damaging information
unearthed?
No
Accept
10-31
No
Credit rating
“fair” and/or other
close to maximum
“line of credit”?
Yes
Yes
Reject
Sample Investigation
Process Flow Chart (Part C)
Stage 3
$30 Cost
Bank, creditor, and financial
statement analysis
Good
Fair
Accept
Poor
Reject
Accept, only upon
domestic irrevocable
letter of credit (L/C)**
** That is, the credit of a bank is substituted for customer’s credit.
10-32
Other Credit
Decision Issues
Credit-scoring System -- A system used to
decide whether to grant credit by assigning
numerical scores to various characteristics
related to creditworthiness.
Line of Credit -- A limit to the amount of credit
extended to an account. Purchaser can buy on
credit up to that limit.

10-33
Streamlines the procedure for shipping
goods.
Other Credit
Decision Issues
Outsourcing Credit and Collections
The entire credit and/or collection function(s)
are outsourced to a third-party company.




Credit decisions are made
Ledger accounts maintained
Payments processed
Collections initiated
Decision based on the core
competencies of the firm.
10-34
Inventory
Management and Control
Inventories form a link between
production and sale of a product.
Inventory types:
10-35

Raw-materials inventory

Work-in-process inventory

In-transit inventory

Finished-goods inventory
Inventory
Management and Control
Inventories provide flexibility
for the firm in:
 Purchasing
 Production
 Efficient
scheduling
servicing of customer
demands
10-36
Appropriate
Level of Inventories
How does a firm determine
the appropriate level of
inventories?
Employ a cost-benefit analysis
Compare the benefits of economies of
production, purchasing, and product
marketing against the cost of the
additional investment in inventories.
10-37
ABC Method of
Inventory Control
Method which controls
expensive inventory
items more closely than
less expensive items.
 Review
“A” items
most frequently
 Review
“B” and “C”
items less rigorously
and/or less frequently.
10-38
100
Cumulative Percentage
of Inventory Value
ABC method of
inventory control
90
C
70
B
A
0
15
45
Cumulative Percentage
of Items in Inventory
100
How Much to Order?
The optimal quantity to order
depends on:
Forecast usage
Ordering cost
Carrying cost
Ordering can mean either the purchase or
production of the item.
10-39
Total Inventory Costs
Total inventory costs (T) =
C (Q / 2) + O (S / Q)
INVENTORY
(in units)
Q
Average
Inventory
Q/2
TIME
10-40
C: Carrying costs per unit per period
O: Ordering costs per order
S: Total usage during the period
Economic Order Quantity
The quantity of an inventory item to order
so that total inventory costs are minimized
over the firm’s planning period.
The EOQ or
optimal
quantity
(Q*) is:
10-41
Q* =
2 (O) (S)
C
Example of the
Economic Order Quantity
Basket Wonders is attempting to determine the
economic order quantity for fabric used in the
production of baskets.

10,000 yards of fabric were used at a constant
rate last period.

Each order represents an ordering cost of $200.

Carrying costs are $1 per yard over the 100-day
planning period.
10-42
What is the economic order quantity?
Economic Order Quantity
We will solve for the economic order quantity
given that ordering costs are $200 per order,
total usage over the period was 10,000 units,
and carrying costs are $1 per yard (unit).
Q* =
10-43
2 ($200) (10,000)
$1
Q* = 2,000 Units
Total Inventory Costs
EOQ (Q*) represents the minimum
point in total inventory costs.
Costs
Total Inventory Costs
Total Carrying Costs
Total Ordering Costs
Q*
10-44
Order Size (Q)
When to Order?
Issues to consider:
Lead Time -- The length of time between the
placement of an order for an inventory item and
when the item is received in inventory.
Order Point -- The quantity to which inventory
must fall in order to signal that an order must
be placed to replenish an item.
Order Point (OP) = Lead time X Daily usage
10-45
Example of When to Order
Julie Miller of Basket Wonders has determined
that it takes only 2 days to receive the order of
fabric after the placement of the order.
When should Julie order more fabric?
Lead time
Daily usage
Order Point
10-46
= 2 days
= 10,000 yards / 100 days
= 100 yards per day
= 2 days x 100 yards per day
= 200 yards
Example of When to Order
Economic Order Quantity (Q*)
UNITS
2000
Order
Point
200
0
10-47
18
Lead
Time
20
38
DAYS
40
Safety Stock
Safety Stock -- Inventory stock held in reserve
as a cushion against uncertain demand (or
usage) and replenishment lead time.
Our previous example assumed certain demand
and lead time. When demand and/or lead time are
uncertain, then the order point is:
Order Point =
(Avg. lead time x Avg. daily usage) + Safety stock
10-48
Order Point
with Safety Stock
2200
UNITS
2000
Order
Point
400
200
Safety Stock
0
10-49
18 20
DAYS
38
Order Point
with Safety Stock
2200
UNITS
2000
Actual lead
time is 3 days!
(at day 21)
The firm “dips”
into the safety stock
Order
Point
400
200
Safety Stock
0
10-50
18
21
DAYS
How Much Safety Stock?
What is the proper amount of
safety stock?
Depends on the:

Amount of uncertainty in inventory demand

Amount of uncertainty in the lead time

Cost of running out of inventory

Cost of carrying inventory
10-51
Just-in-Time
Just-in-Time -- An approach to inventory
management and control in which inventories
are acquired and inserted in production at the
exact times they are needed.
Requirements of applying this approach:




10-52
A very accurate production and
inventory information system
Highly efficient purchasing
Reliable suppliers
Efficient inventory-handling system